As we head into the fall and the days become shorter, it’s time we have a cold hard look at an economic issue which may impact you.
That Hissing Sound
If you live in the Vancouver region, or if you have real estate holdings in the area, you are likely very aware of the major correction in real estate prices. Additionally, if you have read or heard our thoughts at McIver Capital Management, on market corrections in general, this one should come as no surprise.
Universally, all markets correct, and they always will. Commodity, precious metals, stock and bond markets and of course real estate are no exception. While this is true, during the period in which a market is rising quickly, many people feel as though the market never will. This is, in fact, exactly what perpetuates a rising market. As these feelings of inevitability and invincibility take hold of more market participants, rampant speculation begins, pushing prices even higher – and therefore reinforcing the flawed original feeling that the market will never go down again. This creates the speculative bubbles which often end badly for most and that everyone seems to claim, in hindsight, that they clearly saw coming.
But we did see it coming and spoke of it often in our publications, talks and speaking engagements over the past 3 years. The reason why we were confident was because of a very powerful force in nature called ‘normalization’. It’s the same force of nature which makes 1,000 foot tall trees extremely unlikely. We also use market normalization to great advantage on your behalf in our sophisticated investment process.
Simply stated, market normalization is the tendency for all markets to return to their long-term average rate of return from a period of either outperformance or underperformance. If, for instance, the market for a particular asset has a 5% long-term rate of return (measured over several decades or potentially even centuries depending upon the asset) and has recently experienced several years of 20% growth, it makes sense to limit or eliminate your exposure to it because it will indeed normalize. The manner in which a market normalizes can vary greatly. It may fall quickly and give up all those excess gains above 5%, all at once. Alternatively, it may also simply go flat and not move either up or down and normalize through time by generating zero return. Most often, a market will normalize by experiencing a mixture of the two; falling somewhat and then going flat for several years. Either way, exposure to an asset class which has experienced long-term outperformance should limited or eliminated altogether.
The same is also exactly true of an asset that has recently underperformed its long-term rate of return, but clearly it would be in reverse. This would be an asset that it would make sense to increase your exposure to.
What has taken place in Vancouver real estate is a perfect example of market normalization. The only unique thing about this normalization is that the trigger for the correction was taxes.
Politicians Don’t Fix Bubbles
About 3 years ago the narrative regarding Vancouver real estate changed from referring to it as a ‘real estate bubble’ to calling it a ‘housing crisis’, and we knew then that the fix was in. Politicians do not fix bubbles because too many people are at the party making money. But they do smell an opportunity when the word ‘crisis’ is added to the narrative. And they pounced, each level of government eager to get a hand on the profits. What resulted is the present cocktail of real estate taxes, each claiming the moral high ground because the taxes are aimed at ‘fixing’ the ‘crisis’.
We now have the “Empty Homes Tax”, the “Vacancy and Speculation Tax”, the “Foreign Buyers Tax” and perhaps the most cynical of all being the misnamed “School Tax” (which is simply capital appropriation by the Province). The most ominous potential new housing tax, hinted by the federal Liberals when they began making you report the sale of your principal residences for the first time on your tax return, is a potential capital gains tax on your principal residence.
Sand In The Machine
If you throw enough sand in the machine, eventually the machine stops. That’s just what happened to real estate. And it’s much worse than most in the real estate industry would have you believe.
The problem with the real estate industry is that there is virtually no one actually on the side of the consumer. Real estate agents, the real estate boards, banks and lenders, developers and real estate marketing agencies are all on one side of market and all want you to believe that the market will virtually always rise. On our side, we effectively have just the Bank of Canada, whose mandate is to protect the economic future for Canadians.
The reality on the ground is that depending the part of Greater Vancouver you are reviewing; property prices have fallen as much as -30% from the most recent (2019) assessments and as much as -50% from the assessment two years ago.
This is significant on many levels. Those that had been speculating, particularly on borrowed money, may have been caught without a chair when the music stopped and are now being forced to sell. Many of these investors did not borrow from traditional lenders and instead borrowed from dark money pools made available by private lenders. These high interest rate loans were made on the assumption that real estate prices would continue to grow at 15%+ per year. Clearly in financial distress, these sellers are selling at prices which continue to make the entire industry and real estate market unsettled. These sales have also caused some shock waves on both social and traditional media when they have been reported.
Others who have speculated in real estate, but in a less aggressive fashion and with less leverage, will be next to sell, but will likely only do so when the market bottom has been established.
And for everyone else? Billions of dollars in wealth has, fairly suddenly, been eliminated from the local economy. While much of this home equity wealth was only on paper, the evaporation of it has a huge impact on the decisions local consumers make. For most us, our equity in our home is our primary financial asset and the cornerstone on our financial safety. How confident will Vancouverites now be about buying that new car, or going out for that fancy dinner? It’s very likely that many will be less confident to make those spending decisions. This will impact our local economy.
Sand Stays In The Machine
A snap back recovery is very unlikely due to the sand still fouling the machine. Even if events overseas increase the number of people wishing to move to Vancouver, the punishing potpourri of taxes remain. Accordingly, we can expect no massive influx of foreign capital to drive this market back up to the dizzying heights of 2 years ago. Additionally, the sting and physiological damage of this correction will remain for some time.
For the record, I don’t pretend to be a real estate expert. However, we at McIver Capital Management certainly are experts in ‘markets’ in general. Very likely this market normalization correction will result in a -30% to -50% initial correction off the highs from two years ago (which has happened in some areas of the local market already), then eventually bottom and stabilize. It’s likely that the market will remain fairly flat for some time after stabilizing.
We have no crystal ball, but governments change and in time the various tax regimes will change with them. As those changes takes place, optimism will return, and the next real estate cycle will begin. Hopefully we all will be wiser the next time.
Neil McIver is Sr. VP and Portfolio Manager at McIver Capital Management at Canaccord Genuity.
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